In our research coverage, we came across one company which is one of the largest manufacturers of transformer oils and conductors in India/World. Based on both Return on Equity (RoE) and Return on Capital Employed (RoCE) the business seemed to have generated reasonable returns (average) over the long term.
However, the numbers also indicated cyclicality and high leverage (boosting the RoE). Hence, it was crucial to check the company’s financial strength to assess its ability to withstand economic adversities in cyclical downturns.
Leverage and Debt Servicing Ability
|Cash & cash equivalent||1,517||869||4,924||6,109||4,883||4,147||8,320||11,346||2,321||1,057|
|Interest cost/Avg debt||21.4%||35.5%||42.6%||62.9%||37.7%||13.2%||8.7%||9.3%||7.3%||10.1%|
Large cash balance – high interest cost: Disconnect between Balance Sheet, Income Statement and Cash Flow Statement
The company’s Balance Sheets over long term have exhibited net cash position in most years (till FY 2010). However, Income Statements have showed higher interest cost incidence. Low interest coverage has exerted risk to thin net profits.
Moreover, the most intriguing part was high interest yields. Based on the reported year-end numbers company’s effective interest cost went as high as 63% p.a. in some years. As can be seen in the table above, the Balance Sheet picture changed in subsequent years.
Restatement of Numbers
We then tried to understand the reason for change in capital structure in 2011. During our comparative analysis of year on year Balance Sheets we realized that FY 2011’s numbers were restated in FY 2012’s Annual Report. A closer scrutiny with a line by line comparison of restatement of AR numbers revealed following:
|Number reported for FY 2011||In 2011’s AR||In 2012’s AR||Difference|
Owing to the restatement, total debt had increased by Rs. 4,708 million. On the other hand, trade payables had declined by a similar amount.
A closer scrutiny of schedule of Short Term Borrowings showed that till 2011 ‘buyer’s credit’ might have been shown under trade payables and from 2012 it was classified as debt.
Impact of the Restatement
Based on some assumptions we arrived at estimated buyer’s Credit, adjusted net debt and adjusted payables as follows:
|Buyers Credit – Reported||–||–||–||–||–||4,714||7,839|
|Buyers Credit – Adjusted||2,366||2,977||4,518||5,938||3,878||4,714||7,839|
|Net Debt – Reported||(325)||598||(3,861)||(4,432)||(3,193)||2,265||2,182|
|Net Debt – Adjusted||2,041||3,574||657||1,506||684||2,265||2,182|
|Trade Payables – Reported||4,339||5,015||9,461||12,409||9,929||7,035||8,400|
|Trade Payables – Adjusted||1,973||2,038||4,943||6,471||6,052||7,035||8,400|
Now let us see the impact of the restatement on key analytical ratios:
A. Financial Strength and Cash Conversion Cycle
|Net Debt/Equity – Reported||(0.18)||0.28||(1.36)||(1.58)||(1.13)||0.64||0.42|
|Net Debt/Equity – Adjusted||1.11||1.65||0.23||0.54||0.24||0.64||0.42|
|Payables Days – Reported||176||147||237||198||197||101||99|
|Payables Days – Adjusted||80||60||124||103||120||101||99|
|Capital Employed – Reported||3,030||3,634||3,914||4,556||4,526||9,931||15,746|
|Capital Employed – Adjusted||5,396||6,611||8,432||10,494||8,404||9,931||15,746|
Due to inclusion of buyer’s credit in trade payables, the payables period appeared longer giving an impression of lower investment in working capital and faster cash conversion cycle.
It also looked like payables were financing the day to day operations but actually capital employed (long term) in the business was much higher than what was reported.
B. Interest Cost, Cash flow generation and Returns
|Effective Interest Cost – Reported||21.4%||35.5%||42.6%||62.9%||37.7%||13.2%||8.7%||31.7%|
|Effective Interest Cost – Adjusted||11.1%||10.9%||10.1%||12.6%||9.3%||8.8%||8.7%||10.2%|
|WC Changes – Reported||396||(802)||3,425||1,019||(1,673)||(1,049)||(1,326)|
|WC Changes – Adjusted||n/a||(1,413)||1,844||(401)||387||(1,049)||(1,326)|
|OCF as % of Sales – Reported||8.7%||-1.5%||23.3%||7.3%||-4.8||1.2%||0.4%||4.9%|
|OCF as % of Sales – Adjusted||n/a||-5.6%||14.2%||1.7%||4.8%||1.2%||0.4%||2.8%|
|RoCE – Reported||24.7%||24.9%||26.0%||9.6%||22.2%||18.8%||12.1%||19.8%|
|RoCE – Adjusted||13.9%||13.7%||12.1%||4.2%||11.9%||18.8%||12.1%||12.4%|
Thus, the above mentioned accounting treatment of ‘buyer’s credit’ resulted in reporting:
- Lower leverage
- Overstated OCF
- Higher returns on capital ratios
This exercise reconfirmed our strong belief that assessing a company’s quality of earnings is indispensable before using the reported audited numbers. Secondly, instead of studying the Income Statement, Balance Sheet and Cash Flow Statement in isolation, analyzing these three key financial statements in sync with each other is essential for gauging the holistic picture.
And lastly it reiterated that if something doesn’t pass the test of common sense then we ought to be skeptical.
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